The Digital Currency of Tomorrow Is Today's Craziest Bubble

What do you think this is? The title should give you a hint. If the graph is a little hard to read (you can see it in full size at blockchain.info, but no peeking yet!), the market price of this currency starts at zero at the start of 2009 and grows to more than $90 as of a couple of days ago. The smallest available prices in whole cents on that graph don't even show up until the fall of 2010, when the market price was about $0.06. That's right -- in about two and a half years, this currency has grown roughly 150,000%. Even this eye-popping figure dramatically understates its total growth, as you'll see a little further down.

Whatever this is, it sure must be amazing to gain so much value in such a short time. In more than a century, the Dow Jones Industrial Average has only gained about 50,000%, and here we have an investment (or a speculation) that has tripled that return in less than three years.

Have you guessed the currency yet? Here it is:

Right now, you're probably reacting in one of three ways. Most of you are probably wondering what that golden "B" represents. A few of you are probably thinking, "I had no idea Bitcoin was up so much!" or "How the heck did Bitcoin go up that much?" A tiny minority of you are probably cackling about the folly of centrally controlled fiat regimes while your mining rig churns away at another hash.

Yes, our chart is the historical price movement of the Bitcoin, an all-electronic crypto-currency that's taking the tech world -- a small part of it, anyway -- by storm. The Bitcoin's growth is even more absurd when you go into penny-fraction territory -- in early 2010, the currency was worth about three-tenths of a penny, so at its current levels, anyone who held on to their early Bitcoins is sitting on about a 3 million percent return.

Bitcoin basics Let's break down the basics of Bitcoin for the uninitiated.

Bitcoins are created by generating a "hash" -- a chain of cryptographic computation.

Only 21 million Bitcoins will ever be created.

To avoid scarcity problems, Bitcoins can be divided into infinitesimally small fractions.

As more people work to create Bitcoins, each gains less from the same amount of work.

These people are known as "miners," as their efforts vaguely resemble mining.

Mining has not (until recently) been financially worthwhile.

Bitcoins are loosely regulated, but that is changing.

Bitcoin evokes strong reactions from both sides of the fence. A "concise explanation" of Bitcoins on one Bitcoin portal site concludes: "Bitcoin is going to be the biggest opportunity for innovation that the world has seen since the Industrial Revolution. An idea whose time has come." On the other hand, a Bloomberg piece written last week concludes: "Bitcoin ... [is] missing the most essential aspect of money: it's not useful for buying anything. Bitcoin's rise as a tool for financial speculation underlines the failure of the virtual currency idea."

Neither is true. Comparing the whole-Internet equivalent of World of Warcraft gold to the changes wrought on human life by the Industrial Revolution is beyond hyperbole and makes Bitcoin proponents sound like a bunch of googly-eyed lunatics. On the other hand, you can actually buy things with Bitcoin on a small number of sites. However, the truth is closer to the latter than the former -- Bitcoin is a great tool for speculation for a few dedicated techies, but it's a failure as a virtual currency.

Bitcoins, dollars, and the great big gap in between You probably use dollars in your daily transactions (most of our readers are American). Why? The United States is the world's largest economy, backed by the world's largest military. In modern times, the dollar, as currency, has experienced remarkably stable inflation -- with a few hiccups here and there.

Many people who jump into Bitcoin speculation have expressed a certain disdain for "fiat currency." This is especially ironic, considering the fact that Bitcoin is nothing more than a privately created fiat substitute, with nothing supporting its value beyond the market actions of a very small group of users. What can you buy with a dollar? Anything you want, if you have enough of them. What can you buy with a Bitcoin? The options are pretty limited.

In a further irony, much of the recent rise in Bitcoin values is usually attributed to the Cyprus situation, wherein large depositors who are at risk of a haircut off bank account holdings denominated in a relatively stable currency might instead risk their finances on an illiquid "currency" that has already experienced at least one rapid 90% collapse in its three-year history.

The argument for Bitcoin is similar to that for precious metals -- in times of severe crisis, people will turn to a medium of exchange that can't be so easily manipulated by central governments. Compared to Bitcoins, gold and silver, as tracked by SPDR Gold and iShares Silver , have been models of stability. In the time that Bitcoin has twice become a million-plus-bagger, gold is up about 35%, and silver about 60%. Yet despite this comparative stability, you never hear about anyone using gold to buy a pizza with gold. Meanwhile, Bitcoin fetched one early adopter a pizza pie back in 2010, before media hype created its first bubble in 2011. Even if it were feasible, most gold and silver buyers would rather hold on to their metals in the expectation of greater values later.

Let's go back to that crazy chart again. If you have a Bitcoin or 10 in your virtual wallet right now, is your first reaction going to be "I wonder what I can buy with this"? If you think the currency's value will crash, it probably will be -- but if you're one of the faithful (and most people who hold any quantity of Bitcoin are probably still true believers), you're more likely to think that this parabolic rise is only the beginning. Bitcoin $100? Bitcoin $1,000? Sure, why not? In short, you either want to get out in advance of a crash, or you have no intention of spending something that might be worth its digital weight in gold.

Buying something with Bitcoin is a lot like buying something using a thinly traded penny stock. Your employer won't pay you in penny stocks -- you have to go to a specialized website running specialized software to buy it using the dollars deposited in your bank account. After you bought it, you could go to sleep tonight with $10,000 in penny stocks and wake up tomorrow with $20,000 or $20. You can tilt the odds in your favor by manipulating the media or simply bringing enough resources to bear on the tiny penny stock's trading to move prices on your own. Then, even if you succeed at getting your penny stock to double in your sleep, you'll still have to find someone willing to take the penny stock at its higher price in exchange for something else you want (most likely more dollars), and very few traders are willing to do that. And why would you want to dispose of your penny stock after it has just doubled? If it doubled once, it can do so again!

Replace "penny stock" with "Bitcoin," and you have a pretty good idea of how that market works, with one exception: Most penny stock pumpers would kill for the kind of publicity Bitcoin has generated over the last two years. And, despite that publicity, there have been fewer Bitcoin transactions completed over its lifetime than were completed in the stocks of the Dow's 30 components over the course of the most recent trading day.

It's notoriously unstable, it has limited utility, and it's built for the sort of world that would have little use for it. Bitcoins might have made a few early adopters a lot of money by playing to the "greater fool" theory, but it seems to offer nothing for the rest of us.

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